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The Leasing of Rolling Stock for franchised Passenger Services Consultation on the findings of ORR’s market study and on a draft reference to the Competition Commission 29 November 2006 Published by the Office of Rail Regulation The Leasing of Rolling Stock for Franchised Passenger Services Contents Executive Summary.............................................................................................1 1. Introduction....................................................................................................7 2. Passenger rolling stock leasing in Great Britain and the franchising process ...............................................................................................................13 3. Market Definition..........................................................................................23 4. Competition Assessment............................................................................31 5. Conclusions .................................................................................................75 6. Next steps and consultation questions .....................................................89 Annex A – Draft Reference................................................................................93 Annex B – Case Studies....................................................................................95 Annex C – Profitability Analysis .......................................................................99 Annex D – List of stakeholders who responded to our pre-consultation questions ..........................................................................................................133 Annex E - Product market segmentation – views of stakeholders..............135 OFFICE OF RAIL REGULATION • November 2006 The Leasing of Rolling Stock for Franchised Passenger Services Executive Summary Introduction 1. In July 2006 ORR published the scope and provisional timetable of its study into the markets1 for the leasing of rolling stock for franchised passenger services, following a submission from the Department for Transport (DfT). We said that we would consult on our provisional findings in November 2006 and, further, that the consultation might be in the form of a draft market reference. 2. The objective of ORR’s market study has been to establish whether the markets for the leasing of rolling stock for franchised passenger services are functioning effectively, or whether they exhibit features that lead or are likely to distort competition. We note the importance of rolling stock as an input into passenger rail markets and the need to establish certainty for investors in this sector. 3. This document sets out our findings, which lead us to suspect that there are features of these markets which are preventing, restricting or distorting the competitive process. ORR is minded to refer the supply of leasing of rolling stock for franchised passenger services and related maintenance services to the Competition Commission (CC) for a market investigation under section 131 of the Enterprise Act 2002 (EA02). 4. Due to the significance of these markets to the provision of passenger services, we have chosen to consult more widely by way of this document published on our website. We welcome views from all interested parties. 5. Our study has focused on the reference test so as not to prolong the study unduly. We are grateful to all who have engaged with us and who have helped us to come to these preliminary views. 1 We refer to ’markets‘ in the plural throughout this document because, as outlined in chapter 3, we think that there are good reasons to think that there may be distinct product markets for different types of rolling stock. We have not, however, formally concluded on this issue. OFFICE OF RAIL REGULATION • November 2006 1 The Leasing of Rolling Stock for Franchised Passenger Services Preliminary findings 6. In summary ORR does not consider that these markets can be given a clean bill of health. We suspect that there are a number of features which individually or in combination prevent these markets from operating competitively. We consider that the low2 reference test has been met. ORR considers that in the balance of its statutory duties a reference to the CC is a proportionate and appropriate exercise of its discretion to refer, given the concerns that it has identified. 7. The evidence that we have gathered during the course of our study has indicated that, in many instances, Train Operating Companies (TOCs) have very limited choice when it comes to selecting passenger rolling stock for franchised passenger services. In many cases, and for various reasons, a new franchisee has few attractive alternatives other than to re-lease the rolling stock previously in use within that franchise, providing the rolling stock leasing company (ROSCO) that owns that stock with a significant degree of strength in the negotiation of leasing terms. This, we suspect, has led to higher prices and lower quality of service than would be the case in a more competitive market. 8. The DfT, in its submission, produced a wide range of estimates of the level of consumer detriment arising from the ROSCOs pricing above the competitive level. Our own conclusions on profitability are also consistent with excess profits. Whilst our findings are not strong enough for us to arrive at a quantified estimate of consumer detriment or reach a definitive view on the DfT’s precise quantifications, we consider that what we have found warrants further investigation by the CC. 9. Additionally, the TOCs have also expressed concern about the non-capital element of leasing arrangements, relating to such matters as ongoing maintenance and service level agreements. TOCs have mentioned a lack of transparency in transactions and an unwillingness on the part of the ROSCOs to negotiate back-to-back performance regimes to share the risk of poor maintenance on a TOC’s operating performance. In our view such concerns are consistent with markets that are not working effectively. 2 Association of convenience stores v. OFT: “There is, if we may say so, some risk that one may mistake the height of the hurdle…It is a ‘reasonable grounds to suspect’ test’” (Judgement of 1 November 2005). November 2006 • OFFICE OF RAIL REGULATION 2 The Leasing of Rolling Stock for Franchised Passenger Services 10. The lack of choice available to TOCs results from a number of factors (or ‘features’ for the purpose of a reference to the CC), which are either inherent to types of rolling stock or embedded in the way that Government procures franchised passenger services. The key features that may prevent, restrict or distort competition are listed below. • The technical and operational characteristics of rolling stock within Great Britain and its specificity for certain routes and services result in limited interchangeability between different types of stock. • The limited availability of a pool of surplus stock of viable, alternative vehicles restricts the choices available to the TOCs. • Different franchise offer/award dates limit the amount of liquidity during the bidding phase for a franchise. • The costs of transferring stock between franchises act as a barrier to TOCs switching between ROSCOs. • The specificity within some Invitations to Tender (ITTs) can restrict the choices available to TOCs. • Section 54 undertakings, where they exist, can direct use of the incumbent stock. • The commercial case for introducing new build stock is limited by its high cash costs. • The time limited nature of railway franchises relative to new build lead times disincentivises new build. • The DfT’s deliverability criteria in the franchise process encourages TOCs to lease stock for the entire duration of franchises. • The higher rental cost of short-term leases, and uncertainty over the value of call options and the precise circumstances in which they can be exercised, tends to favour retention of incumbent stock. OFFICE OF RAIL REGULATION • November 2006 3 The Leasing of Rolling Stock for Franchised Passenger Services • New build activity is limited in the absence of Government support. • Buyers (TOCs) have limited incentives to negotiate over lease terms given that rolling stock costs are passed through into subsidy or premium payments. 11. Another relevant factor is the growth in passenger demand since privatisation, which has led to a limit to the volume of surplus stock available. 12. It is evident that a number of these features arise from Government policies. We recognise that the way in which DfT discharges its responsibilities for the procurement of passenger railway services is a matter for Government, and that franchising policy is driven by a number of considerations of which the terms on which rolling stock is leased is only one. These may not be amenable to change if the Government does not see net benefits in funding and/or performance terms in doing so. 13. There is a balance to be struck and we believe that it is important to secure the alignment of incentives between the franchise objectives and other industry relationships to ensure a satisfactory outcome for all concerned. The DfT is of the view that, and we suspect that, the ROSCOs are charging higher lease charges than would be the case in a competitive market. We consider that changes to the current approach to franchising could facilitate addressing this. 14. We are aware that there may be uncertainty during the reference period but we would hope that this would not affect the relationships between